Tuesday 27 February 2018 by Asmita Kulkarni Education (advanced)

APRA’s proposed revision to the bank capital framework

APRA's latest revision targets higher risk lending and outlines a simpler capital framework for small authorised deposit taking institutions. This note details the key proposed changes

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APRA, the Australian bank regulator, released a consultation paper earlier this month on the proposed revision to authorised deposit taking institutions’ (ADIs) capital framework. To mitigate risk, each financial institution must set aside capital as part of the long standing Basel reforms, and most recent Basel III revisions, to reduce risk and improve the mortgage lending framework. The paper outlines the main components APRA expects to make to the risk based capital requirements for ADIs. 

The key proposed changes are:

  • Lower risk weights for low loan to value ratio (LVR) mortgage loans, and higher risk weights for interest only loans and loans for investment purposes, than apply under APRA’s current framework
  • Amendments to the treatment of exposures to small- to medium-sized enterprises (SME), including those secured by residential property under the standardised and internal ratings based (IRB) approaches
  • Constraints on IRB ADIs’ use of their own parameter estimates for particular exposures, and an overall floor on risk weighted assets relative to the standardised approach
  • A single replacement methodology for the current advanced and standardised approaches to operational risk

The proposed changes are credit positive for banks as they address the systemic concentration of residential mortgages in ADI portfolios, by targeting higher risk lending such as investor loans and interest only loans.

As of January 2018, over 60% of ADIs’ total loans were residential mortgages. 

The paper also outlines a proposal for a simpler capital framework for small ADIs. It seeks to reduce regulatory burden without compromising prudential soundness. APRA will aim to ensure the difference between the average risk weight under the IRB model used by larger banks and the standardised approach used by smaller banks is not so large that it creates competitive distortions.

While the paper provides no quantification on the likely impact on individual banks we would expect risk weighted assets (RWAs) for banks to increase as a result of these proposals. RWAs are used in determining a bank’s minimum capital requirements. 

“We expect risk weighted assets (RWAs) for banks to increase as a result of these proposals”

A proposal to increase risk weights for certain assets will effectively result in reduction of reported capital ratios even though there is no change to the bank’s underlying risk profile or amount of capital held. APRA expects that, if ADIs meet the benchmarks set out in July 2017 for ‘unquestionably strong’ capital ratios, any changes to the capital framework should be accommodated by existing capital, without the need for any additional capital raisings.

APRA also stated that it has started a discussion on implementing a leverage ratio for ADIs. The leverage ratio is a non risk based capital ratio, which is calculated by dividing Tier 1 capital by the bank’s average total consolidated assets. The minimum requirement is 3% under Basel III but APRA is considering a higher minimum requirement of 4% from July 2019 for IRB ADIs. We expect most banks will be able to meet this regulatory benchmark.

Click here to see APRA’s announcement.

The following are acknowledgements made by the major banks to APRA’s proposed revision. 

Westpac

“We welcome these releases as it is a further step in finalising capital rules for Australian banks. While further detail is required, Westpac believes it is well positioned to meet the new requirements given our strong capital position and the implementation dates of 1 July 2019 for the revised leverage ratio methodology, and 1 January 2021 for the revised capital framework” – Peter King, Westpac Group Chief Financial Officer. Read more here

National Bank Australia

In July 2017, APRA advised that ADIs using Advanced Internal Ratings Based models would require Common Equity Tier 1 (CET1) ratios of at least 10.5% by January 2020 in order to meet the unquestionably strong benchmark. NAB continues to expect to meet APRA’s 10.5% target in an orderly manner by January 2020. As at 31 December 2017, NAB’s CET1 ratio was 10.2%. Read more here

The Australian Prudential Regulation Authority (APRA) is the prudential regulator of the financial services industry. It oversees banks, credit unions, building societies, general insurance and reinsurance companies, life insurance, private health insurers, friendly societies, and most members of the superannuation industry. APRA currently supervises institutions holding approximately $6 trillion in assets for Australian depositors, policyholders and superannuation fund members.


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